Section 40A(2) of the Income Tax Act - Terminologies Explained

Section 40A(2) of the Income Tax Act serves as a critical checkpoint for the tax department to ensure that business transactions remain transparent and fair. When a business owner pays a family member or a closely connected associate for goods or services, there is a natural temptation to inflate those expenses to reduce taxable profits. This provision empowers Tax Officers to scrutinize such payments. If the amount paid exceeds the prevailing market rate, the excess portion is disallowed as a business expense. It protects the integrity of tax collection by mandating that all related-party dealings mirror real-world market conditions.

Understanding Section 40A(2)

The primary goal of Section 40A(2) is to prevent tax evasion through the shifting of profits. In a typical business scenario, an entity might pay a high salary to a relative who doesn't actually work, or buy raw materials from a sister concern at double the market price.

By doing this, the profit of the main business stays low, and the income is parked with a relative who might be in a lower tax bracket. Section 40A(2) acts as a barrier to this practice, ensuring that only reasonable expenses are deducted from business income.

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Key Terminologies Explained

To navigate this section, you must understand three specific terms that form the backbone of any tax audit regarding related parties.

1. Excessive or Unreasonable Expenditure

The law doesn't define excessive with a fixed percentage. Instead, it relies on the Fair Market Value (FMV). If you buy a laptop for your office for ₹80,000 from your brother, but the same model is available at Croma or Amazon for ₹50,000, the ₹30,000 difference is considered excessive.

2. The Assessing Officer's (AO) Opinion

The power to disallow an expense rests with the AO. However, this isn't arbitrary. The AO must prove that:

• The payment was made to a specified person.
• The payment is not in line with the market rate or business needs.

3. Specified Persons (The Related Parties)

The definition of a specified person changes based on the type of business structure you have.

Entity Type

Who is a Specified Person?

Individual

Any relative (Spouse, brother, sister, lineal ascendant/descendant).

Firm (Partnership/LLP)

Any partner of the firm or any relative of that partner.

Company

Any director of the company or any relative of the director.

HUF

Any member of the Hindu Undivided Family or their relatives.

Substantial Interest Holders

Anyone holding 20% or more voting power or profits in the business.

The Scope of Relative under Section 2(41)

In the context of an individual taxpayer, the term relative is specific. It includes:

1. Spouse (Husband or Wife).
2. Brother or Sister (including step-siblings).
3. Lineal Ascendants (Parents, Grandparents).
4. Lineal Descendants (Children, Grandchildren).

Note: In-laws are generally not included in this specific list for Section 40A(2), though they may fall under other sections like Section 56(2).

Criteria for Disallowance: The Three-Step Test

For an expense to be hit by Section 40A(2), the tax department follows a logical flow:

1. Identity Check: Is the payment made to a person mentioned in the Specified Persons list?
2. Comparison Check: Is the expenditure higher than the Fair Market Value of the goods, services, or facilities provided?
3. Legitimacy Check: Is the expenditure legitimate for the business needs of the taxpayer?

If the answer to these is Yes, the excess amount is added back to the business income and taxed accordingly.

Practical Examples & Scenarios (2025-26 Perspective)

Scenario A: Excessive Salary to a Spouse

Mr. Arjun runs a digital marketing agency. He hires his wife, Mrs. Priya, as a Creative Consultant and pays her ₹2,000,000 per year. Mrs. Priya has no background in marketing and does not attend the office.

• Tax Impact: The AO can disallow the entire ₹2,000,000 if no service was rendered, or a significant portion of it if the market rate for a consultant with her (lack of) experience is only ₹500,000.

Scenario B: Renting Property from a Director

A private limited company operates out of an office owned by its Managing Director. The company pays ₹500,000 monthly rent. Similar offices in the same building are rented for ₹300,000.

• Tax Impact: Under Section 40A(2), ₹200,000 per month (the excess) will be disallowed as an expense for the company.

Substantial Interest: The 20% Rule

A crucial part of this section involves Substantial Interest. A person is deemed to have a substantial interest in a business if:

• In a Company: they own shares (directly or indirectly) carrying not less than 20% of the voting power.
• In Other Cases: they are entitled to not less than 20% of the profits at any time during the previous year.

If Business A owns 25% of Business B, any transaction between them will be scrutinized under Section 40A(2).

Domestic Transfer Pricing vs. Section 40A(2)

It is important to distinguish this from Specified Domestic Transactions (SDT).

• Section 40A(2) applies to all businesses making payments to relatives.
• Domestic Transfer Pricing (Section 92BA) applies only if the aggregate value of such transactions exceeds ₹20 Crores in a financial year.

If your transactions are below ₹20 Crores, you don't need the heavy documentation of Transfer Pricing, but you still must satisfy the reasonableness of Section 40A(2).

Compliance Checklist for 2025-2026

To avoid litigation and disallowances, businesses should maintain the following documentation:

1. Market Benchmarking: Keep screenshots or quotes from third-party vendors for similar services to prove the Fair Market Value.
2. Qualification Records: If paying a high salary to a relative, maintain their CV, job description, and proof of work (emails, reports, etc.).
3. Board Resolutions: For companies, ensure related party transactions are approved in board meetings and documented in the minutes.
4. Invoicing: Ensure the related party issues a proper tax invoice with GST (if applicable).

Impact on Tax Audit Report (Form 3CD)

For businesses subject to a Tax Audit, the Auditor is required to report these transactions under Clause 23 of Form 3CD.

The auditor must list:

• Name of the related person.
• PAN of the person.
• Relationship.
• Nature of the transaction and the amount.

Failure to report these accurately can lead to penalties for both the taxpayer and the auditor.

Conclusion

Section 40A(2) is not meant to stop you from doing business with your family or associates. It is simply a fairness rule. As long as you pay your relatives what you would pay a stranger for the same work or product, you are on safe ground. Transparency and documentation are your best friends here. By maintaining clear records of how you arrived at a price, you can easily justify your expenses to the Income Tax Department and avoid unnecessary tax burdens.